The Fed Has Decided the Phillips Curve Is Wrong after All – Robert Aro (10/01/2020)

Chairman Powell at the August 27 Jackson Hole symposium emphasized what he sees as the malleability of economic theory, noting that the apparent tradeoff between inflation and unemployment, known as the Phillips curve, hasn’t been working as once hypothesized. He alluded to an era when the curve allegedly worked better than it does now:

In earlier decades when the Phillips curve was steeper, inflation tended to rise noticeably in response to a strengthening labor market.

Strange, because for many decades Austrian economists raised concern about the theory, asserting that correlation does not equal causation. While Powell doesn’t acknowledge the efforts made by Austrians, he somewhat agrees. The framework used generations ago may no longer be relevant.

During the September 16 Federal Open Market Committee (FOMC) meeting, he noted the “new framework” and the move away from the unemployment/inflation tradeoff:

The good news is we think we can have quite low unemployment without raising troubling inflation.

This may sound new but Powell said almost the exact same words to Congress in July of last year:

I think we really have learned though that the economy can sustain much lower unemployment than we thought without troubling levels of inflation.

Vice Chair Clarida, in an August 31 statement, takes the idea one step further by appearing to rationalize the “flat curve” as reason to push for the importance of inflation expectations:

This is especially true in the world that prevails today, with flat Phillips curves in which the primary determinant of actual inflation is expected inflation.

Twentieth-century mainstream economists—until recently—have generally asserted that unemployment is a primary determinant of actual price inflation. But now that Fed economists have concluded the Phillips curve has flattened this can no longer be said. In our new era, “expected inflation” is the “primary determinant.” It’s a vague term, but as Clarida explains, it can be “inferred from surveys, financial market data, and econometric models.” This approach hinges on the Fed influencing the market to instigate higher inflation which manifests itself into higher prices; a theory impossible to prove.

The following day Governor Lael Brainard similarly bent reality by referencing the “flat curve” to justify low interest rates:

With a flat Phillips curve and low inflation, the Committee would have to sustain the federal funds rate below the neutral rate for much longer in order to push inflation back to target sustainably.

At least she’s honest when affirming low rates are “conducive to increasing risk appetite, reach-for-yield behavior, and incentives for leverage” ultimately leading to more economic instability.

Finally, September 23 delivered the final nail in the coffin when Vice Chair for Supervision Randal K. Quarles stated:

This recent experience in the United States, which has also played out elsewhere, has led to a growing consensus in the economics profession that the relationship between unemployment and inflation—commonly known as the Phillips curve—has flattened.

It’s not that the Phillips curve, invented over sixty years ago, once worked and now inexplicably doesn’t. It never worked at all. A theory must work at all times to be considered credible, not just when it’s convenient. What’s worrisome is that the Fed’s mandate centers around inflation and unemployment. But with no tradeoff between the two, the Fed’s balancing act must be called into question.

[RELATED: “The Phillips Curve Myth” by Frank Shostak]

As for the Fed, we will never get a concise version of their stance. However, it appears they have come to terms with there being little, if any, tradeoff between inflation and unemployment. They won’t admit to implementing an obsolete theory. Therefore, it must be the curve that has changed.

This creates a new error. Rather than taking the opportunity to reflect on what went wrong, they, in effect, doubled down on their mistake. Using the unresponsiveness of the curve as an opportunity to be free of long-standing economic constraints, the Fed “freed” itself. Inflation expectations, low rates, and money supply expansion can continue indefinitely to help bolster job growth, all while seeing minimal effects of price inflation; only now, the flat curve can be incorporated into a new narrative, some unnamed theory, the equivalent of disabling a car’s onboard computer system to drive over a cliff at an even faster velocity.


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